Estimating your profit (or loss) from rental properties is not an exact formula. There’s no way you can predict what your vacancy rate will be. There’s no way you can accurately predict your expenses. Our next lesson covers expenses you didn’t see coming. When estimating profit or loss, you should always create two scenarios – best case and worst case. The best case scenario will show the maximum profit you can expect. The worst case scenario will show the maximum loss you’ll sustain. Chances are your actual earnings will fall somewhere between the best and worst case scenarios.
In any business venture, gross profit is determined by subtracting expenses from the income. Gross profit is what you have left after normal operating expenses. From that you must subtract your income taxes to determine the net profit. Let’s say your rental units earn $36,000 and the total operating expenses are $21,000. Your gross profit would be $15,000. Depending on the amount of other income you have, your income taxes could be anywhere from 0 to 39.6%. Of course you’ll also have to pay social security on your self-employment earnings but that’s beyond the scope of this course. For this example, your net profit would be determined by subtracting the income taxes from the gross profit of $15,000.
The worst case scenario for rental properties is one you swear will never happen. What if all of your tenants suddenly decide to stop paying rent? What if a fire destroys the building and you forgot to obtain business interruption insurance? Your commercial property insurance might pay to rebuild the dwelling but you won’t have any rent coming in until the building is finished. You must determine a worst case scenario in order to figure out your maximum projected loss. Most rental investors believe the worst case scenario would be having half the rental units empty at any given time. In the example we used above, instead of your rental units earning $36,000, they might earn only $18,000. If your expenses are $21,000, you’ll sustain a $3,000 loss.
The following list of common rental expenses is far from being complete. You can consider this a preliminary checklist of possible expenses you might incur when determining your best and worst case scenarios.
Refrigerator, stove, dishwasher or garbage disposal dies
Furnace needs repair or replacement
Central heat/AC needs repair or replacement
Insects, bugs or rodents
Stairs fall through
Water leaks under sink, from toilet, or from tub/shower
Faucets, shower, or tub won’t stop dripping
Hot water heater or thermostat dies
Toilet is plugged and can’t be plunged
Broken door knobs or locks
Holes in walls
Screen or storm doors won’t close or latch
Loose railings or handrails
Light fixtures or electrical outlets short out or show exposed wires
Broken window or door screens
Your rental agreement might state that the tenants are responsible for any damage they cause, but they might refuse to pay if they claim the damaged item wasn’t properly maintained or was in need of replacement, which is why it broke. As the property owner, you must fix certain things regardless of who is at fault. If a tenant rips an electrical outlet out of the wall and the fire department notices it during an inspection, you’ll receive the written violation and probably be fined, not the tenant.